Volume II, edited by Robert C. Effros, contains the collected views of banking and legal expers, gathered at the second IMF-sponsored seminar of central banks general counsels. Matters of both international and domestic concern are addressed. The contributors analyze topics ranging from concepts of international monetary law to aspects of the debt crisis and the role of the international financial institutions; banking development in the United States, the United Kingdom, the European Union, and elsewhere; developments in the payments systems; and measures to counter money laundering.

When my former colleague, Christopher Thompson, addressed the 1988 seminar, he felt it necessary to explain at some length the history and background of the Basle Committee of Supervisors.1 Around that time, there were suspicions that the Committee was some kind of secret cabal intent on world domination of the banking industry. In the United States, for example, where freedom of information is paramount, this offended instincts to such an extent that Congress instructed the General Accounting Office to investigate the Committee’s activities. Its subsequent report2 fortunately dispelled the worst fears and concluded that the Committee was a body of responsible bank supervisors trying to address common problems in a coherent manner. I hope I can persuade you to come to the same conclusion.

This paper addresses three main topics. First, it addresses the framework agreed upon by the Committee in July 1988 as a basis for convergence in the capital standards of major international banks; second, some aspects of the Basle Concordat, which have a bearing on questions relating to the legal status of branches of banks; and finally, the supervisor’s role in the prevention of money laundering. These are just three of a wide range of issues that the Committee has addressed over recent years.

First, though, is a brief review of the Committees’s origins and history. The Committee, whose original title was the Committee on Banking Regulations and Supervisory Practices, was set up by the Group of Ten (G-10)3 Central Bank Governors at the end of 1974. Its purpose was to provide a forum for confidential discussion on the handling of specific problems, to coordinate supervisory responsibilities for international banks, and to enhance supervisory systems and prudential standards. The immediate trigger for the Committee’s establishment was the Herstatt and Franklin National Bank crises,4 but the Governors had become progressively aware of the need to strengthen collaboration between banking supervisory authorities in view of the growth of international banking markets and of the similarity in the problems facing banking supervisory authorities in different countries.

The Committee, whose members are senior officials of the central banks and supervisory agencies of the countries of the G-10 and Luxembourg, now meets four times a year at the Bank for International Settlements (BIS). Its secretariat, which is provided by the BIS and is based in Basle, was originally very small but now consists of four professional supervisors on temporary secondment from Committee member institutions, plus myself.

A question often asked is what is the legal status of the Committee’s documents, recommendations, and so forth. The answer is that they are not binding in any legal sense. They seek to persuade through force of logic as opposed to force of law. However, since the endorsement of the G-10 Governors is sought for the major initiatives, they do have a certain weight behind them. Moreover, much of the Committee’s current work has a parallel in developments in the European Community, and the Directives that result from these discussions in Brussels are enshrined in Community law. This is, however, a matter more of interest to lawyers than to the general public, since the Committee’s objective is to draw on the experience of members in order to reach a consensus on the best supervisory practices. While the implementation of that consensus is a matter for national supervisory authorities, there is often self-interest in adopting policies in line with recommendations. Frequently, our members welcome a statement from the Committee to support their attempts to improve national supervisory arrangements. Members do not normally try to water down the recommendations to defend the interests of their banks, although it is, of course, necessary to take into account the particular circumstances (for example, institutional, legal, or accounting) in each country.

Capital Accord of 1988

The first of the main topics is the 1988 capital accord. The document itself is unpretentious. It is written in layman’s language and deliberately avoids the precision of a legal text. There are no “whereas” clauses and it is not called an “accord” or “agreement,” but rather a “statement” or a “framework.” It is not signed, and while it claims to have been “endorsed” by the G-10 Governors, the Governors’ press statement of July 11 does not add any extra commitment to the statement in the paper itself that “the national supervisory authorities represented on the Committee intend to implement [the accord] in their respective countries.”

Let me at this juncture dispel one common misconception: these are not in a literal sense BIS standards or guidelines. The fact that the Committee meets at the BIS and that the BIS provides its secretariat implies support for the work, but there is no formal BIS participation in the Committee, apart from its secretariat. These are G-10 guidelines.

Despite the “soft” language in the final text, the discussions that led up to it were in many ways a negotiation process, because the participants were well aware that, at the end of the day, their institutions would be committed to adapt their own national rules to make them consistent with the outcome. Without in any way approaching the legal status of a treaty, therefore, the agreement is considered to be binding on its members and the text states that the Committee will monitor its application.

One of the merits of this somewhat curious procedure is that individual members of the Committee have been free to interpret the agreement in their own jurisdictions in the most effective manner. It is no surprise that financial engineers have been exercising their undoubted ingenuity in uncovering possible loopholes in the rules. Fortunately, members of the Committee were from the outset alive to the danger that, if a concession was made in one jurisdiction, supervisors elsewhere would come under pressure to make similar concessions. Since it is in the interest of no party, including the banks, for the agreement to unravel, procedures were set up so that members could bring problems to the Committee at an early stage and develop a joint response. In practice, the Committee has made some tough and some would say arbitrary decisions in order to avoid establishing precedents that could lead down a slippery slope. Thus, one can say that the primary objective of strengthening the capital of international banks took precedence over the letter of the agreement. Such a robust attitude would have been much more difficult to enforce had the agreement been drafted in precise legal language.

Perhaps the most gratifying aspect of the transitional period has been that many of the supervisory authorities in other countries with international banks have adopted, or are in the process of adopting, the 8 percent capital standard (in some cases with modifications to suit their own market place). As a result, there are now few banks operating internationally that are not effectively subject to the same set of minimum standards of capital adequacy. This is an achievement comparable with that of many longstanding international organizations with far more extensive formal powers. Some have even claimed that banking is the only industry subject to effective regulation on a worldwide basis.

It has been noticeable that despite the relatively long transitional period that we felt was needed to allow time for countries and banks to modify their national arrangements, there has been unexpected readiness in the market place, partly under pressure from the rating agencies, to advance the pace of adjustment. One effect has been a wider appreciation of the fact that a bank’s reputation will be enhanced by demonstrating a capital position stronger than the minimum. Another has been the pressure on international banks domiciled outside the G-10 to observe similar standards. These processes have not only tended to compress the transitional period but have also encouraged a welcome impetus away from regulatory laxity.

Perhaps fortunately, the period since the agreement was first conceived has for the most part been economically prosperous in most countries. This has meant that banks have been able to raise their capital both by retaining some of their significant profits and by raising new capital in the market on reasonable terms. Strong stock markets made a substantial increase in new issues of bank capital possible without a damaging effect on bank stock prices. This was particularly the case in Japan, where very large amounts of capital were raised.

Lively attention5 has been given to the equality of competition that the agreement6 has achieved or failed to achieve. It is true that a more level playing field is one of the accord’s objectives (albeit subsidiary to the principal one of raising the general level of capital). However, many factors outside the control of bank supervisors are just as relevant to the ability of banks to compete on equal terms. Taxation is particularly crucial, as are bank accounting conventions. Whether assets are valued at market price or at historic cost can significantly affect net worth. Already, however, there are signs that the capital agreement has led to additional pressure on the accounting profession to narrow their differences, and it may be that similar incentives may develop for the narrowing of tax differences. The structure of the domestic banking system and the degree of permissible competition are other areas where the supervisor has little influence. Finally, the cost of bank capital itself depends not only on the profitability of each country’s banking sector but on the overall cost of capital in the economy. Thus, Japanese banks, for example, have had a considerable advantage over banks from other countries, where earnings yields for quoted companies are in general much higher. Nonetheless, despite the different national conditions, the chances appear good that the capital agreement will achieve its objective of reversing the persistent decline in bank capital ratios through the 1980s and leaving the world’s major banks more strongly placed to face the challenges of the 1990s.

Basle Concordat of 1983

The Basle Concordat was originally written in 1975 but reviewed and reissued in 1983. It sets down a blueprint for collaboration between the host and parent supervisor of a foreign banking establishment.7 As such, it is very much an “insider” document for the reference of supervisors. It is designed to prevent problems and does not necessarily have any bearing on where responsibility should lie if a problem arises. The experience of supervisors and central banks is that each banking crisis has its own individual features and it is therefore counterproductive to seek to lay down prior rules on liquidity support or potential liability vis-à-vis depositors or creditors. For this reason, the paper specifically states that it does not address the lender of last resort aspects of the role of central banks.

Two basic principles lie at the heart of the document: first, that no foreign banking establishment should escape supervision, and second, that the supervision should be adequate. The first objective is addressed by giving both host and parent authorities a role; thus, host authorities are responsible for the operation of foreign banking establishments in their territories as individual institutions, while parent authorities are responsible for them as parts of larger banking groups. Supervisors use the term “consolidated supervision” to refer to the ability of a parent authority to monitor the operations of a banking group on a global basis. The responsibilities of host and parent authorities are both complementary and overlapping.

The implementation of the second basic principle, namely that the supervision of all foreign banking establishments should be adequate, requires judgments of supervisory standards. If a parent authority judges that the supervision by a host authority in which one or more of its banks are operating is inadequate, it is expected either to extend its own supervision to cover the foreign establishments concerned or to discourage their continued operation. Conversely, if a host authority considers that the supervision exercised by a parent supervisory authority is inadequate, it should discourage the local operation of banks from the country or should set specific conditions on the business to be conducted. Note that the judgment of the quality of supervision is left to the individuals concerned. This allows a supervisor to make the judgment in the light of his or her own supervisory capacity. The Committee did consider the possibility of some multilateral scoring system, but quickly rejected it as being too inflexible as well as raising major difficulties of application. Instead, arrangements were introduced to inform supervisors about the supervisory arrangements in other countries so that they were better placed to make the required judgments.

The text of the Concordat, as that of the capital agreement, is in layman’s language and has no pretensions to act as more than a practical guide to who-does-what. It distinguishes between three types of foreign establishment: (1) branches, which, having no separate legal status, are integral parts of the parent bank concerned; (2) subsidiaries, which are legally independent institutions owned by an entity incorporated abroad (not necessarily a bank); and (3) joint ventures, which are legally independent, locally incorporated institutions. These distinctions are important because they determine the manner in which supervision and supervisory collaboration can most effectively be carried out, particularly in relation to the ability of the parent supervisor to exercise effective consolidated supervision.

The view has been expressed to me—by a lawyer, naturally—that the law in some countries, of which the United States is one, does not support the precept that a head office and its branches are a single legal entity, so that the liabilities of one are not necessarily the liabilities of the whole. Some countries, of course, demand endowment capital for branches. The object may be to provide protection to local depositors, but it can also be for monetary reasons (that is, to ensure a commitment of foreign capital). Where endowment capital is the rule, the head office is less free to “milk” the unit to meet possible losses in the rest of the group. If an international banking group fails, the host supervisor in countries that apply a “separate entity” approach can freeze a healthy branch’s assets and preserve those assets from the clutches of the liquidator for the benefit of depositors of the local branch.

The integrity of the banking group is also an issue in the opposite case, in which a branch is unable or unwilling to repay its depositors, who then turn to the head office for restitution, as in the cases of Chase’s Saigon and Citibank’s Manila branches.

The attitude to this question taken in the Concordat, and indeed in all the Committee’s work, is not based so much on legal as on practical circumstances. When a member of the public makes a deposit with a branch of a major bank, he or she is assuming that the bank is standing behind that branch. This assumption is not misplaced, since no bank can expect to thrive if it is seen to walk away from the liabilities of a branch, no matter what the legal position may be. For this reason, the Basle Concordat assumes that the solvency of banks and their branches are indivisible and gives the parent supervisor the task of ensuring their solvency. Essentially, the purpose is to lessen the chances of failure through effective supervision. If, at the end of the day, a failure results, it is accepted that there is no certainty that the legal resolution of the problem will be consistent with a consolidated supervisory approach. But do not forget that the Concordat also places a duty on the host authority to supervise individual units.

The Basle Committee has now issued a so-called Supplement to the Basle Concordat,8 which examines certain practical aspects of information exchanges between supervisory authorities. There are two particular aspects of interest for lawyers. One section of the text concerns the authorization of new banks. This section contains recommendations designed to ensure that banking licenses are not given to unsuitable applicants. This is a very different angle to that currently being pursued in the GATT and in the EC to promote freedom of access to foreign banks. The two goals, however, are not inconsistent; the Committee favors competition in the banking sector, but not at the cost of admitting weak entrants who might create future problems for the sector as a whole.

A second area of interest to lawyers in the new Supplement to the Concordat concerns the ability of supervisors to exchange information with foreign authorities free from legal constraints. One of the problems identified in the initial Concordat issued in 1975 was the duty of professional secrecy in many jurisdictions that prohibited supervisors from passing information, particularly where this concerned individual customers. In practice, the sensitivity is almost entirely on the liability side of the balance sheet, and it is comparatively rare for a supervisor to be worried about the identity of individuals providing a bank’s funding sources. What supervisors are often concerned about, however, is the use of those funds and in particular whether a bank has an excessive exposure to a single borrower. The Supplement therefore urges that countries should exempt supervisors from secrecy constraints subject to four conditions:

(1) the information received should be used only for purposes related to the prudential supervision of financial institutions and should not be released to other officials in the recipient’s country not involved in prudential supervision;

(2) the arrangements for transmitting information should be reciprocal in the sense that a two-way flow should be possible, but strict reciprocity in respect of the detailed characteristics of the information should not be demanded (because if perfect reciprocity were the rule, it is likely that few information exchanges would be possible);

(3) the confidentiality of information transmitted should be legally protected, except in the event of criminal prosecution;

(4) the recipient should undertake, where possible, to consult with the supervisor providing the information if he or she proposes to take action on the evidence of the information received. Supervisors can therefore supply information in the knowledge that if the news is bad they will receive warning of any precipitous action on the part of the recipient.

Statement of Principles on Money Laundering of 1989

Let me close with a few words about money laundering. This is a very topical issue, on which an international Financial Action Task Force9 has made recommendations to governments.10 The recommendations concerning the behavior of financial institutions, which constitute over half of the 40 recommendations, elaborate on the Statement put out by the Basle Committee in January 1989.11

A few years ago, it would have been difficult to conceive that the Basle Committee, which deals with concerns about the prudential soundness of banks, would have become involved in this topic at all. However, the Committee’s higher profile became a target for the U.S. Congress, who directed the U.S. members of the Committee to bring the matter to our table. Initially, there was some reluctance to deal with it, because there were questions of legal competence for at least some of the Committee member institutions.

What is the bank supervisor’s interest in this matter? In a sense, it can be of supervisory concern if a bank gains a reputation for being less than selective in accepting clients’ money. That does not relate to the traditional concern for solvency or liquidity, however, unless the sums are so large that there is some form of funding risk or a risk of confiscation. Hence the reason for addressing the issue at all was perhaps more a desire to see the ethics of banking maintained than a concern for the prudential soundness of banks.

The Committee’s consideration of this issue resulted in a Statement of Principles designed to be distributed to banks worldwide. The Statement has been endorsed by a wide range of non-G-10 supervisors, including all members of the Offshore Supervisors’ Group (a committee of supervisors from all the major offshore centers). It consists of a preamble and four basic principles: know your customer; comply with the law; cooperate with the police; and train your staff adequately.

The first principle, knowing or identifying a customer, is not always as easy as it sounds. It is common practice in some countries, Japan for example, for depositors to use fictitious names in financial transactions. In others, notably Switzerland, there are large numbers of fiduciary and tax lawyers who act as nominees for depositors. The Statement stops short of saying that customer identification is obligatory, but it does use fairly strong language for those cases involving large transactions or safe custody facilities. It does not, however, tackle the question of beneficial ownership, that is, the nominee problem, which is a particularly complex one as our Swiss colleagues are experiencing. It seems that the Task Force also failed to find a satisfactory solution to this matter.

The second principle, complying with the law, raises a number of interesting questions. First, it is necessary to consider what is the nature of the offense of money laundering. There are two aspects to this and when you consider them you will see that the thrust of the Basle Committee’s Statement is somewhat different from that of the Task Force. Whereas the latter paper focuses almost exclusively on narcotics (Recommendation 5 advocates extending the scope more widely), the Committee’s Statement does not. Indeed, drug trafficking is not mentioned in the Statement itself and only as an example in the preamble, and no definition of money laundering is provided.

The way the Committee approached the matter was to consider the nature of the crimes it was seeking to inhibit. We balked at debating the relative gravity of insider trading, arms trafficking, gambling, and even prostitution, but there was a clear understanding that “criminal activities” included all the main categories of serious crime, such as kidnapping, terrorism, extortion, and robbery, as well as trafficking in drugs. There was some debate as to whether the text should rule on the ethics of soliciting nonresident deposits that contravene civil but not criminal law, such as tax or exchange control regulations. However, it was decided that this was outside the scope of the Statement.

Instead of listing the crimes, then, the Committee’s Statement advocates that banks should not deliberately set out to “facilitate transactions which they have good reason to suppose are associated with money laundering activities.” The Task Force has made a valiant attempt to define money laundering.

The third principle in the Statement, namely cooperation with law enforcement authorities, raises some interesting questions of international law. The key question is whether a bank should trigger an investigation by notifying the authorities of suspicious transactions. This was held to be outside the competence of the Committee to recommend because of the legal implications for which other national authorities were responsible. It is, however, one of the Task Force’s proposals and a consequence is that some countries will need to amend their bank secrecy rules accordingly.

While the Committee’s Statement does not require banks to report suspicions about their customers, it does suggest that they should take steps to close or freeze suspicious accounts and to sever relations with the customer concerned. One cannot deny that banks are confronted with tricky conflicts of interest over this matter. Equally, however, I have a clear sense that the obligation on financial institutions to refuse dirty money is going to increase. A bank will in the future have to weigh the benefits of acquiring cheap funds against the potential costs of loss of reputation, fines and other penalties, or, in extremis, the withdrawal of its license.

The final principle deals with the need to see that bank staff are trained to carry out the necessary procedures and that internal auditors monitor compliance. This specifically includes retaining internal records so that there is always an audit trail of transactions (as has also been recommended by the Task Force). There is little support in the Committee for U.S.-style requirements12 for banks to report large cash transactions, on the grounds that it is costly for the banks and does not prevent cash entering the banking system elsewhere. There is also a reluctance to see supervisors given detailed responsibility for ensuring banks’ compliance with money laundering procedures, since they are already fully stretched monitoring banks’ risk taking. This task is seen as more appropriately one for the justice and police authorities.

I will close with a few initial reactions to the recommendations of the Task Force. First, I was interested to note that the recommendations would apply on a cross-border basis—in the banking supervisors’ jargon, there would be a “consolidated” approach to the problem. Thus, a bank would be responsible for compliance by its branches and subsidiaries abroad. It is not clear to me how easy it would be for the recommendations to have extraterritorial application. Some, such as training staff to reject dubious transactions, or keeping adequate records, could be applied on a worldwide basis. But the reporting of suspicious transactions to the law enforcement agencies would surely be hampered by local secrecy regulations.

The Basle Committee has a certain amount of experience with extraterritorial law: its unilateral application is resented without prior consultation with the local authorities. However, with suitable collaboration, workable solutions can be reached. In the case of drug trafficking, even countries with very strict secrecy laws may well be willing to comply with an internationally coordinated initiative. It might, for example, be possible to agree on a formula whereby a branch or subsidiary of a foreign bank would inform the law enforcement authority in whose jurisdiction it was operating before its head office or parent bank notified its own authorities. Joint notification might prove acceptable even in those countries that do not adopt the recommendations.

A second point of interest in the Task Force’s paper is the description of money laundering techniques in the introduction and, later on, the distinction drawn between the different stages in the money laundering process. First, there is the physical conversion or disposal of large sums of small-denomination bank notes (known as “smurfing”). Then there is what is called “layering,” that is, the conversion of the money into a different form, for example into gold or jewels, into a different currency, or into the hands of a reputable owner. At the third stage, the money becomes part of the banking system. The usefulness of these distinctions is that they draw attention to the weak points at which the illicit source may be identified. Once the third stage has been reached, it would be very difficult to track down the origin.

Finally, I was intrigued by the report13 that money laundering commissions (that is, the fee for the conversion of illegal funds) had widened from 2-4 percent of principal in the early 1980s to 6-8 percent in 1990. Perhaps this means that the Committee’s Statement and other efforts are indeed having an effect.

COMMENT

WILLIAM TAYLOR

I read Mr. Freeland’s paper with great interest. As a member of the Basle Committee, I remember the discussions being sometimes acrid. The Committee has been very effective mainly because all members understand that we are not really talking about the details of negotiability or non-negotiability or floating or fixed rates. We are really speaking to very broad principles that would guide banking safety, soundness, and reasonable competition standards.

The nature of the agreement on capital is an example. It has been extremely effective in overcoming what was developing into a significant weakness in the international banking system: a lack of owner equity. All of the parties involved have taken it to heart, although they are not obligated in any contractual way to follow the agreement. In the United States, the agreement has been a major force for increasing bank capital, as well as reserves. Because I have been working on the oversight board of the Resolution Trust Corporation, I can understand what happens when one does not have capital, when things go off the edge, and when standards are not followed.

Savings and loan associations are thrifts. They had assets of approximately US$1.3 trillion. Yet between 400 and 500 of them became insolvent. The U.S. Government took over these institutions and placed them in conservatorship. The government had to bear the resulting loss, amounting to many billions of dollars. From the financial statements, one is driven to wonder how these institutions got so far out of hand. It is a question of not understanding the proper valuation of assets, the right kinds of requirements relating to investor capital.

The work of the Basle Committee is essential as we enter the period of banking consolidation around the world. Worldwide consolidation can be expected. It is necessary to agree not only on capital standards but also on payment systems standards to ensure that the world banking system is made safe for participants, because all participants are more interdependent now than they have ever been.